TOKYO
(Reuters) - When Prime Minister Shinzo Abe vowed at the
World Economic Forum in Davos to take a "drill bit" to
the "solid rock" of vested interests in reforming
Japan's economy, executives at companies such as General
Electric and IBM paid attention.

In the months that followed the January appearance at Davos,
blue-ribbon panels sought out GE and IBM for advice on how to give
companies more flexibility in hiring and pay.

But the labor market deregulation to be announced on Tuesday, as
part of an economic package aimed at boosting investment in Japan
and lifting growth, stops far short of the sweeping change foreign
business leaders had sought.

That marks a setback at a time when investor optimism about the pace
of "Abenomics" reforms has ebbed. The Nikkei stock index, a closely
watched indicator for Abe's closest advisors which rose more then 50
percent in 2013 as investors cheered the first blast of Abenomics,
is down 5 percent this year.

"Changes in labor regulations will be incremental. It's a step
forward, but it's not that big," said Robert Feldman, chief
economist at Morgan Stanley MUFG in Tokyo.

The story of how Abe's promised deregulation faltered on job market
reforms when confronted by resistance from Japan's bureaucracy and
political controversy illustrates the challenge for Abe's "Third
Arrow", a growth strategy intended to boost private investment and
compliment earlier programs of fiscal stimulus and monetary
expansion by the Bank of Japan.

Although Abe's reform panel sought ideas from companies such as Ikea
and Danone in recent months, the crucial decisions were made
behind closed doors by about half a dozen Tokyo bureaucrats over a
few days in June, according to interviews with 11 people who
participated in the process.

The result: a pledge to end compulsory overtime allowance for
workers earning more than the equivalent of $100,000 per year, a
change affecting less than 4 percent of Japan's workers.

The more contentious question of how and whether to make it easier
for companies to fire workers was left unanswered with the
government pledging to find a "place for debate" on the issue next
year. Both rules on overtime and firing will be further discussed in
a council at Japan's Ministry of Health, Labour and Welfare, where
unions have a strong voice and have made it clear they will fight to
prevent change.

"It's true that right now it is only limited to the group which
supports competitiveness the most, but I think it is still
meaningful to offer them to be able to work according to new rules,"
said Makoto Murayama, the labor ministry official in charge of
negotiations.

"We can't go ahead looking only at the economic impact, but also
have to protect the workers and gain the understanding of the
citizens."

LONG HOURS, LOW PRODUCTIVITY

At a London event targeting foreign investors in May, Abe seemed to
promise a lot. "Japan's population is declining. In order to grow,
we must raise productivity," he said in answer to a question. "We
need to reform labor market regulation in order to make working
conditions more flexible."

Abe's comments suggested that he was aiming at an overhaul of
Japan's lifetime employment system. That entrenched practice gave
workers secure jobs until retirement and was a feature in Japan's
astonishing economic rise in the 1960s and 1970s. But it has been
unraveling since an asset bubble burst in the 1990s and proponents
of reform argue that a freer job market would lift growth and
incomes.

"This is a system that was built up over 30 or 40 years bit by bit,"
said Junji Annen, Chuo University Law School professor who advises
on one of Abe's reform panels. "No one thinks it can go on like
this, but they are scared to change it."

The Japanese work long hours, but remain far less productive than
workers in the United States or the European Union. Rules on firing
are complicated and the outcome is uncertain for employers. In part
because of the unpredictable costs of restructuring in a downturn,
employers are reluctant to hire full-time. Almost 40 percent of
workers are in a temporary class with limited protections and fewer
benefits.

Between the start of the year and April, representatives of Abe's
economic reform team sought ideas from foreign companies such as
Procter and Gamble [PGEO.UL] and Unilever <ULVR.L> on the changes
they wanted to see in labor regulation.

In March, John Rice, GE's vice chairman, appealed directly to an
Abe-appointed panel on foreign investment to give employers more
flexibility and make it easier for employees to move between
companies.

"If labor mobility is high, productivity would go up and we could
take on the challenge of managing through the business cycle," Rice
said, according to a transcript of the Japanese translation.

IBM, which has clashed with Japanese unions over its dismissal of
workers who received below-average appraisals, was also consulted,
officials involved in the process said.

GE confirmed its executives talked to the government and provided
the transcript of Rice's appearance at the panel. IBM Japan's
spokesman Takeo Tamagawa declined to provide the details of
consultations, but said that two main issues discussed with the
government were the flexibility of working arrangements and a
working culture in which workers were evaluated based on
performance, not the time spent at work.

'NO OVERTIME'

Japan's rigid labor laws allow almost all workers to claim overtime
if they work more than eight hours a day or 40 hours a week, with a
narrow exception for executives and some occupations.

Labor unions say the rules prevent abuses and "karoshi", the
coined-in-Japan term for death by overwork.

"The people who die by overwork in Japan are mostly white collar
workers," said Yosuke Minaguchi, a lawyer specializing in labor law.
"These are not laborers toiling in factories but they also need
protection."

For his part, Abe has wanted to take on overtime rules since his
first brief stint as prime minister in 2006 and 2007, officials
involved say.

But a plan to carve out a "white collar exemption" for overtime in
Abe's first term met strong opposition and contributed to a decline
in his support ratings. This time, advisers say, he wanted to make
sure that any reforms would not be characterized as an attempt to
strip hard-working voters of overtime that could cost him support.

"The prime minister had one request. To clarify to the public the
difference between this proposal and the previous one," said Futoshi
Nasuno, a Ministry of Economy, Trade and Industry official who
prepared drafts of the policy proposals.

After the consultations that included IBM and GE, the advisory panel
proposed two kinds of exemptions from overtime allowance – one for
mid-level managers and creative workers and another based on income
for high performers earning more than about $100,000 per year, a
threshold taken from a precedent in the United States.

Then, in late April, Asahi Shimbun, Japan's second-largest
newspaper, ran a front page story that raised questions about
whether the exemption was so broad it would amount to a "no overtime
pay" policy. The leak of the plan put the advisory panel on the
defensive, officials involved said.

Wary of a public backlash, Trade ministry officials from the
government's reform taskforce decided to narrow their demand to seek
an exemption only for those earning more than $100,000. The
exemption was so limited that officials decided not to even run an
economic simulation of what it would mean for growth or income.

Around the same time, trade ministry officials who were pushing
reform were running up against resistance from the labor ministry on
the wording of the final policy plan.

"We were pushing to get specific dates and implementation periods
for our projects into the bill. We asked for concrete words like
'establish' and 'create'. The labor ministry would come back with
'consider' or 'study' and vague commitments for implementation,"
Akiko Sugahara, who joined the government reform taskforce from
business lobby group Japan Association of Corporate Executives told
Reuters.

Foreign investors had asked for changes to Japan's labor law, which
gives broad discretion to judges in settling dismissal cases. As a
result, labor-related cases take on average, twice as long as other
civil cases, court data show.

In the end, the Abe plan commits only to further debate on a
"dispute resolution system" by stakeholders. Labor unions are
already girded for a fight.